Buckle Your Seat Belts for October

By Paul Hoffmeister, Chief Economist

This month, there will be a lot going on macroeconomically that could move markets significantly. On October 10, US-China trade negotiations will be held in an attempt to break the deadlock both sides have reached in recent months; a European Union summit will take place on October 17, and Brexit will be the top issue; the FOMC will meet on October 29-30; and the current, official deadline for Brexit is October 31. All the while, political uncertainty is erupting as Congress undertakes an impeachment inquiry of President Trump.

As we see it, the world’s most important macro variables are “in play” during the next 30 days. In this client letter, we will answer some of the most popular questions related to these issues.

Is the US going into a recession? It’s getting too close for comfort.

Will the more than 3-year uncertainty over Brexit finally culminate with the UK’s exit from the EU by month-end? People might be sleeping on this scenario; it has a higher probability of happening than some might believe.

Will the US and China put an end to their trade dispute, which arguably sparked the big US equity selloffs in May and August? Prospects are good for a partial deal; not so good for a comprehensive settlement.

What’s the 2020 election outlook and policy implications? It appears that it’ll be Trump v. Warren, but don’t count out Hillary Clinton. Also pay attention to healthcare providers, which seem to be the most sensitive sector to election news.

Lastly, would a presidential impeachment be a serious market risk, and are Republicans in trouble in 2020? Yes, we believe it’s a serious market risk when considering how markets traded during the late summer of 1998 when the Clinton impeachment events began to heat up. As for Republican electoral prospects next year, they could be even stronger if the 1998 midterms are a clue. Furthermore, the Trump re-election campaign may be the most formidable in history in terms of money, and its voter targeting has so far been a competitive advantage versus Democrats. 

Is the US economy going into a recession?

While I’ve been a critic of Fed policy in recent years, I believe there’s a good chance that the economy can still avoid recession.

To be clear, I’ve been critical of the Fed’s interest rate increases during the last 1-2 years because: 1) it was intentionally sought by many supporters as necessary to ensure that the economy didn’t overheat (I disagree with the notion that too many people working is a bad thing, and that low unemployment can spark an inflation spiral); and 2) rate increases were excessively flattening and inverting the yield curve (which is an ominous forward-looking indicator).

Arguably, the combination of higher interest rates and macro uncertainty that’s inhibiting risk-taking, such as trade frictions and Brexit, have been the primary factors behind the economic slowdown we see today. And the US economy is inching closer to recession.

According to the Institute for Supply Management, the ISM Manufacturing Index peaked in August 2018 at 60.8 and the Non-Manufacturing Index peaked a month later (September 2018) at 60.8 as well. As of September 2019, the indices respectively registered 47.8 and 56.4, indicating that the US manufacturing sector was contracting while the non-manufacturing sector was still growing albeit at a slower pace than a year ago.

Given this economic data and the fact that the 3-month/10-year Treasury spread is inverted by approximately 18 basis points today, according to the St. Louis Federal Reserve, it’s understandable that recession fears are mounting and growth is likely trending toward 1%. But the good news is, despite the economic damage of the last year, recession could be avoided.

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First, interest rate futures at the Chicago Mercantile Exchange currently imply an 88.3% probability of another quarter-point rate cut by year-end, which could lift much of the yield curve out of inversion. Second, many Fed officials are no longer focused on the unemployment rate, but on external risks, such as the global slowdown and trade tensions. Third, the job market remains in decent shape. It’s not as strong as a year ago, but it’s not meaningfully deteriorating either. Fourth, some credit market spreads have narrowed this year, suggesting a healthier risk-taking environment today compared to late 2018, early 2019.

The confluence of these factors could keep the United States out of recession during the near-term.

Without question, though, we believe major negatives continue to weigh on the economy, such as the weak manufacturing sector and the uncertainty surrounding Brexit and US-China trade. Resolution and clarity in both could spark a resurgence in global growth. Contrarily, the more these uncertainties drag on, the greater the headwinds to growth.

Importantly, it has been hugely positive that the Fed has been more dovish this year and has undone two quarter point rate increases already. In our view, we need the Fed to remain dovish, and markets likely won’t be pleased if Fed policymakers question whether further rate reductions are necessary.

It’s worrisome, for example, to see that some Fed officials seem to not yet be convinced about cutting rates further before year-end. For example, on Monday September 30, Chicago Fed President Charles Evans said: “What we’ve done already might be sufficient, I’m open minded to suggestions that we might need more. At the moment I’m going to be looking at the data.”[i] Arguably, it would be best for equity markets if public comments from Fed officials were consistent with the high likelihood already priced in by markets of another quarter point cut at one of the last two FOMC meetings of 2019. 

The current Brexit deadline is October 31, and it has been more than three years since voters in the UK passed their historic referendum to leave the European Union. Are we only weeks away from this finally happening?

Arguably, the biggest mystery in markets today is whether Brexit is going to finally happen at the end of this month.

The UK Parliament recently passed legislation to prevent a no-deal Brexit, and the UK’s Supreme Court ruled that Prime Minister Boris Johnson’s suspension of Parliament was unlawful. Notwithstanding, Johnson continues to insist that the UK will leave the EU on October 31.

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By the end of August, the Predicit betting market was suggesting a greater than 50% probability of Brexit occurring by November 1st. That probability plummeted in early September when the House of Commons passed legislation to force a delay.  

It appears that Johnson will deliver to the EU in the coming days a new Brexit proposal, the central feature of which would be the elimination of the backstop deal his predecessor Theresa May crafted and instead installing customs checks between Northern Ireland and the Republic of Ireland. It’s a long shot attempt to reach a deal with EU leaders who will be meeting on October 17-18.

If a deal isn’t reached, it’s unclear whether Johnson will simply force Brexit to happen automatically on the Halloween deadline, even though many UK lawmakers will call it unlawful. Given that Johnson’s rise to become Prime Minister was rooted in his promise to deliver Brexit “deal or no deal” and that his top adviser, Dominic Cummings, was the chief architect of the 2016 “Vote Leave” campaign, it’s possible that Johnson will ignore Parliament, force a no-deal Brexit, cast the dispute as the people versus the establishment, unveil major tax and trade plans to support the no-deal economic scenario, and call on lawmakers to hold new elections – thereby leaving his leadership and policy methods to the will of the people, rather than to Parliament. It would be a major economic and political gamble.

Currently, the Predictit betting market gives only a 21% probability of an official Brexit occurring on November 1. This could be an underestimation. It’s likely in our view that this variable will heat up in the coming weeks and markets will be dealing a serious possibility of Brexit actually happening at month-end. 

What’s the probability of a comprehensive agreement between the US and China by year-end?

In sum, the trade conflict with China is arguably so large and multi-faceted that a comprehensive agreement is highly unlikely to happen soon. That said, it’s very possible we will see a partial agreement.

First, to understand the enormity of the trade dispute with China, it’s important to understand the perspective of the Trump Administration. In December 2017, the Administration released its National Security Strategy for the United States, making clear that the country “will no longer tolerate economic aggression or unfair trading practices.”[ii]

Then on June 28, 2018, in a speech at the Hudson Institute, White House trade advisor Peter Navarro outlined six strategies of economic aggression used by China against the United States:[iii]

1)    Protect China’s Home Market from Imports and Competition;

2)    Expand China’s Share of Global Markets;

3)    Secure and Control Core Natural Resources Globally;

4)    Dominate Traditional Manufacturing Industries;

5)    Acquire Key Technologies and Intellectual Property from Other Countries, including the United States; and,

6)    Capture the Emerging High-Technology Industries That Will Drive Future Economic Growth and Many Advancements in the Defense Industry.

Navarro then outlined fifty “acts, policies and practices that China engages in in order to promote its economy worldwide.”[iv] After discussing many of these strategies and tactics, Navarro ominously concluded his speech by saying, “If you’re in a negotiation, and you take 25 of these off the table in a successful negotiation, you still have 25 left.”[v]

From this perspective, the extent of the US-China trade dispute is simply too large to be resolved anytime soon. And, if many important issues are fixed, many other important issues will remain unresolved that will still need to be addressed.

Therefore, it’s not surprising that in August, in the face of the negotiating stalemate between the US and China as well as ever-rising tariffs, US-China relations looked like they were at a multi-year low. Importantly, though, circumstances might be turning for the better that could make it possible for a partial deal to be reached between the two countries.

First, the trade deals that President Trump is reaching with various countries (Japan, Korea, Mexico, and Canada) and the trade barriers being installed against China could be increasingly separating China from the rest of the world. This may mean China will need to flatten the playing field if it wants to play inside the US economic sphere.

Secondly, the Chinese economy seems to be progressively suffering. The economic data for August showed that China’s exports shrank by nearly 1%[vi]; arguably a dangerous development for an export-led economy. So the trade battle and US tariffs seem to be taking a toll on the Chinese economy, and putting pressure on Chinese leaders.

And lastly, as it stands now, top US and Chinese officials are scheduled to reconvene in Washington in the coming weeks. According to Peter Navarro, those talks will focus on two key issues: ending China’s policy of subsidizing state-owned companies and opening up the Chinese market to American competition.[vii]

It’s noteworthy that the talks will center on these issues and not on others, such as IP theft and forced technology transfers. This may signal that both sides are focused on small wins, rather than getting everything done at once, which will be much harder.

It’s unlikely a comprehensive trade deal will be reached between the US and China during the next year, but there appears to be a good chance that we’ll see a partial deal. This will probably mean that some tariffs will stay in place for a long time, but at least we’ll see some progress compared to the very pessimistic outlook that existed in early August.  

What is your 2020 presidential election outlook and the policy implications?

At the moment, it appears that the presidential election will be Donald Trump v. Elizabeth Warren.

The Democratic Senator of Massachusetts has sky-rocketed in the polls and betting markets. According to a September 19-23 poll by Quinnipiac University, Warren is winning 27% of Democratic voters and independents who lean Democratic, compared to 25% for former Vice President Joe Biden; Bernie Sanders is in third place with 16%. Note in August, Biden was at 32%, Warren 19%, and Sanders 15%.[viii]

In betting markets, Warren’s prospects of winning the Democratic nomination are even more promising. According to Predictit, Warren’s probability of becoming her party’s nominee is 47%, versus 25% for Biden and 11% for Sanders. To highlight just how quickly and far she has ascended in recent months, Warren was at 19% in early July.

Warren’s notable policy positions are Medicare for All, a wealth tax, rolling back the Trump tax cuts, dividing commercial and investment banking units at large financials, and requiring private equity firms to assume debt and pension costs of acquired companies.

As we’ve highlighted before, the most sensitive sector to the election outlook has arguably been healthcare providers, which are now down nearly 20% during the last year. They’ve been notably weaker during the last month despite the strength in the broad market. We believe this is in response to Warren’s political ascendancy.

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Of course, the Democratic primary season is still far off, with the Iowa Caucuses scheduled for February 3, 2020. Four months is a political eternity, and therefore anything could still happen. It’s worth monitoring Hillary Clinton for the possibility of her entry into the race. Clinton has a new book being released and will do more public appearances; and with the Trump impeachment inquiry, the argument may grow even more among her supporters and some independents that the 2016 elections were illegitimate.  

Is the possibility of a Trump impeachment a major market risk? Are Republicans in trouble in November 2020?

Yes, an impeachment process could be a major market risk. But its likelihood appears low to us.

In previous client letters, we’ve highlighted our view that the Clinton impeachment events during the late summer of 1998 may have contributed to a nearly 15% decline in the S&P 500. That’s a useful precedent to consider when thinking about the market implications of a Trump impeachment, especially in light of the major, market-friendly corporate tax cuts that could be undone in 2021 with a new administration.

Of course, the validity of an impeachment inquiry and trial is currently divided along party lines. The key developments we are watching for here are whether any Republican senators would cross party lines in favor of conviction in a Senate trial, as well as the public’s appetite to impeach the President.

Removal from office would require a two-thirds majority in the Senate. Republican political consultant Mike Murphy told MSNBC’s Andrea Mitchell on September 25 that one Republican senator told him that if a secret vote were held, at least 30 Republican senators would support impeachment.[ix] But we haven’t seen more reports of that view. For now at least, there appears to be no indication that the President lacks the support of most of his party in the Senate.

As for public opinion, a recent Monmouth poll found 52% oppose impeachment and removing the President. This is hardly the support some Democratic leaders have hoped for in order to pursue impeachment. Although she supports an inquiry today, House Speaker Nancy Pelosi said in March that she opposed impeachment because: “Unless there’s something so compelling and overwhelming and bipartisan, I don’t think we should go down that path, because it divides the country.”[x]

For now, the prospects of President Trump being impeached may be overestimated by some.

Furthermore, it isn’t necessarily clear that Republicans are in trouble in the next election. President Trump may have created the most formidable re-election campaign ever. According to the Washington Examiner, Trump’s campaign and the Republican National Committee raised $125 million during the third quarter 2019, raised $308 million during the first three quarters of the year, and had more than $156 million the bank. To underscore the scale of this fundraising, President Obama raised just $70 million during the third quarter of 2011.[xi]

The Trump campaign and the RNC may raise $1 billion in this election cycle. Even more, and perhaps speaking more to the new political environment caused by the new impeachment push, on September 24th they ran a fundraising drive in response to Democrats’ inquiry. By the end of the day, $1 million was raised.

This unprecedented fundraising could be powerful given Trump’s competitive advantage in terms of voter targeting. In March, in an interview with CNN, Howard Dean, who is in charge of the Democratic National Committee’s data analytics and targeting infrastructure, acknowledged: "I think, right now, we're not competitive. [Republicans] been doing this the right way for two cycles and you know the DNC has really started out in a hole. You know, we have basically 12 months or so to get us in shape."[xii]

Furthermore, the impeachment inquiry may not necessarily be a serious political wound for Republicans, but an advantage if the public doesn’t meaningfully support the undertaking. The Clinton impeachment precedent may again be instructive. During the weeks leading up to the 1998 midterms, Newt Gingrich had been expecting to pickup 10 to 40+ seats in the House. Ultimately, Republicans lost 5 seats.[xiii]

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

*******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

[i] “Charles Evans says Fed has turned dovish, but still might need to do more,” by Holly Ellyatt, September 30, 2019, CNBC.

[ii] “National Security Strategy of the United States of America”, December 2017, the White House.

[iii] Speech at Hudson Institute by Peter Navarro, June 28, 2019, Hudson Institute.

[iv] Ibid.

[v] Ibid.

[vi] “China’s exports fell unexpectedly in August as US trade war continues to slam industrial economy,” by William Zheng, September 8, 2019, South China Morning Post.

[vii] “Navarro: US and China will discuss these two issues in next round of trade talks”, by Evie Fordham, September 8, 2019, Fox Business.

[viii] Warren Continues To Climb While Biden Slips Quinnipiac University National Poll Finds; Democratic Primary Is Neck And Neck”, September 25, 2019, Quinnipiac University Poll.

[ix] Andrea Mitchell Reports, September 25, 2019, MSNBC.

[x] “Pelosi: ‘I’m not for impeachment of Trump”, by David Alexander, March 11, 2019, Reuters.

[xi] “Trump and Republicans break fundraising record and bring in $125m haul”, by Zachary Halaschak, October 2, 2019, Washington Examiner.

[xii] “Money, Power, and Data: Inside Trump’s Re-Election Machine”, By Jeremy Diamond, Dana Bash and Fredreka Schouten, March 19, 2019, CNN.

[xiii] “The 1998 Elections: Congress – The Overview; G.O.P in Scramble over Blame for Poor Showing at the Polls”, by Alison Mitchell and Eric Schmitt, November 5, 1998, New York Times.

Don’t hold your breath for the EU’s Waterloo: it will not disintegrate

by Thomas Kirchner & Paul Hoffmeister

August 15 marked Napoleon’s 250th birthday. Doomsayers used that anniversary to compare the failure of his pan-European empire to the current state of the EU. But we believe that the comparisons with and predictions of the demise of the European Union completely miss the point of where today’s EU stands. Without question, the EU has its problems, including a stifling bureaucracy and policies that suffocate growth and innovation. However, missed in most criticisms of the EU and predictions about its future is the consideration of its significant net benefits that will make it survive longer than many critics currently believe.  

European empires

The present-day EU differs from prior pan-European empires, whether Napoleonic or that of Charlemagne a millennium earlier, in its voluntary nature.  It is not an empire assembled through war. Napoleon’s empire building is estimated to have cost six million lives, and massacres and ethnic cleansing ordered by Charlemagne are likely to have had a lower death toll only because of a lower overall population at the time.

The EU did not conquer its member states. Instead, states couldn’t wait to join. For Eastern Europe’s former Soviet vassals, EU membership was a major step into modernity, not a defeat in the face of an overwhelming enemy. Comparisons between the EU and failed empires are not just silly, they are plain wrong.

Aristocrats, scholars and monks

A better analogy for the EU today than short-lived empires are the lives of Europe’s aristocracy up to the French revolution. They constituted a European Union of aristocrats of sorts, with a common market for crowns and titles. While it is tempting to compare fallen empires to today’s because we tend to think in national categories with each country having more or less well-defined borders, that was only a secondary part of how people thought long ago. While the majority of the population lived in servitude and was unable to leave the land, several superstructures transcended borders of towns and principalities.

For royalty and aristocrats, what we would refer to as national origin today played no role in the award of a title. It was not uncommon to see a crown or other title conveyed upon someone with no attachment to the land. Leopold I became the first King of Belgium upon its independence, after he turned down the crown to the throne of Greece and after having served in the Russian army. [i] Coming from the German dynasty of Saxe-Coburg-Saalfeld, he had no relation to either of these countries. Similarly detached from his territory was Frederic II of Prussia, who is said to have spoken only broken German, which didn’t matter because the official Court language was French anyway, and he was fluent in that. [ii]

The clergy and laic scholars led lives similarly detached from what we would call national origin today. Monastic orders established their own rules and regulations that formed communities across the continent. Scholars and students in universities were afforded a special status by the church equivalent to clergy and were encouraged to spread knowledge across Europe, in particular by the exemption from the residency requirements applicable to clergy. In fact, the EU refers to this medieval scholarly mobility to justify one of its fundamental principles, freedom of movement. The business community has a similarly Europe-wide history to look at, with Venetian bankers and traders or their Dutch counterparts dominating the continent’s trade routes during different time periods.  

These pan-European structures existed long before the creation of the nation state. Therefore, the idea that the nation state is a more appropriate framework for political, economic and intellectual life than the EU is not supported by history. In fact, most of these pan-European behaviors disappeared only once the French revolution eradicated medieval societal structures; and in its wake the nation state took hold as the new normal.

The nation state was an artificial creation, so artificial that the French had to spend much of the 19th century teaching their population the official French language. People spoke Basque, Breton, Flemish, Occitan or numerous other languages before the forced adoption of French as the national language. It is important to remember that medieval pan-European structures were destroyed only by the establishment of these artificial nation states. The often-repeated criticism today that a globalized elite had taken control of society and was trying to eradicate the nation state implies that it would have been normal in the past that such elites felt constrained by nation states, when in reality no such limitations existed.

The fact is, leaders thinking beyond national borders today is a return to historical normalcy in Europe after two centuries of nation state exceptionalism. Hence, today’s EU is by no means an artifact but a return to wide networks that grew naturally when they weren’t inhibited by artificial borders.

Tangible benefits of EU membership

In the present day, EU membership conveys to countries clear and tangible benefits, which is the main attraction for joining, as well as a major hurdle for leaving.

There is not just the obvious benefit of direct access to a market of over 500 million consumers, which is almost twice the size of the U.S. market. EU membership also comes with a set of unified rules and regulations that can be implemented in domestic regulations without constituting an impediment for market access. For smaller countries, this is a particularly significant benefit.

Imagine if companies had to adhere to 26 different national regulations to access 500 million consumers. Most likely, companies would create versions of their products and services only for the top markets and simply ignore smaller countries such as Slovenia (pop. 2 million), Bulgaria (pop. 7 million), Malta (pop. 460,000) or Finland (pop. 5 million).

Almost two thirds of EU member States have a population of 10 million or less. [iii] These countries would not be able to function in the same manner as large, developed countries if it were not for EU membership. Any advantages from a higher degree of sovereignty from leaving the EU would soon be offset by their mutation into banana republics. Brexit is a viable option for a large member state like the UK and potentially Italy, but it could be economic suicide for smaller member countries -- and even the threat of leaving lacks credibility.

Contrary to the view of some critics, EU membership restores some degree of sovereignty to smaller member countries that would otherwise be lost. Consider approval of new drugs, for example. As an EU member, a small country has some say in how drugs get approved in the EU. However, as non-EU members, a country like Portugal (pop. 10 million) [iii] would probably be last in line for large pharmaceutical companies to introduce new drugs. So its citizens would either not get the benefit of these drugs for years after their introduction in larger countries. Alternatively, these smaller countries could rubber stamp the approval in a larger neighbor, which of course means that they will have no say at all in the process. EU membership conveys clear advantages over going solo. The departure of these smaller, poorer countries from the EU is less feasible than a secession of Manhattan from the U.S.

Common market in lieu of a free trade zone

The EU and its predecessors starting with the 1951 European Coal and Steal Community (ECSC) between Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany [iv] were deliberately designed as common markets rather than free trade zones. In the eyes of its founders, free trade zones gave their members too much leeway in favoring domestic firms over importers by blocking market access through consumer protection and safety, environmental or myriad other regulations. A good example of such non-tariff barriers is Japan’s treatment of imported Perrier water bottles, which for years were required to feature health warnings, while domestically-bottled water that did not go through customs did not have such warnings. Not surprisingly, Perrier struggled to compete with Japanese bottled water despite reaping the benefits of a free trade agreement.

Crucially, the ECSC was under the control of a High Authority, the predecessor to today’s European Commission, as a supranational executive that was to enforce the treaty. Unlike in a free trade area, where enforcement and implementation are both national responsibilities that open the door to abusive and manipulative practices, the supranational character of the enforcement body, supplemented by a judiciary and parliamentary oversight body, eliminated room for gaming the system and simultaneously kept the system current. The latter point is particularly important for the stability of common markets compared to free trade zones. This institutional framework, which has been modernized in today’s EU from the 1951 ECSC, is what makes the common market function and helps to overcome attempts of individual nations to gain an advantage.

The recent NAFTA renegotiation illustrates this distinction well: NAFTA remained static since it was signed by President Clinton in 1993. It took punitive tariffs and the threat of even more punitive tariffs to get the parties to agree to update the treaty to reflect the changes in the economy that had occurred over the quarter century since its inception. Now imagine if the EU lacked its institutional framework and instead had to renegotiate its free trade pact bilaterally in a similar way as the U.S. did with Canada and Mexico. What worked between three nations in the Americas only after major trade frictions would be completely impractical in a 28-nation European free trade block. It is the EU’s institutional framework that keeps the common market updated, relevant and practical.

From a common market to a common bureaucracy

That is not to say that the EU is not deeply troubled. The European Commission follows the universal bureaucratic logic of regulatory creep. Thus, the common market has morphed into a common bureaucracy.

This logic ends up producing ridiculous rules from time to time, such as the attempted regulation of the curvature of cucumbers, bananas and other produce which was scrapped after a public uproar in 2008; or the classification of carrots as a fruit because otherwise the interaction with another rule would have prevented the Portuguese from making carrot marmalade, a local delicacy.

Part of the problem is the dominance of the bureaucracy over the institutions. Parliament would normally be the institution to limit bureaucratic excesses. But the European Parliament is caught in a chicken-and-egg dilemma: because it has little power, often “misfits” volunteer to be elected as Members of the European Parliament (MEP). And because of the preponderance of misfits among MEPs, not many want to give the parliament more power. Many MEPs represent fringe opinions in their political parties, and fringe parties use the European Parliament as a platform to publicize their agendas. In the last election, a record number of MEPs with colorful biographies were elected, including two from Germany’s joke party Die Partei whose leader refers to himself as a “demotivation coach” and stated openly he was running for office only to collect the generous perks. Therefore, the reluctance to cede more powers to this institution is understandable, and as a result its ability to reign in the executive remains limited.

Similarly, national parliaments are too far removed from the decision-making process. The European Commission proposes a new regulation to a council composed of government ministers, who then approve, reject or modify the regulation. When something proves to be unpopular, ministers will blame “Brussels” for it, even though they signed off on it themselves. National parliaments, for a variety of mostly practical bureaucratic reasons, fail to oversee their ministers’ and bureaucrats’ actions in the council. As a result, the national executives like to use the EU to implement policies that would have little chance of going through national parliaments. 

Unfortunately, it is unlikely that these shortcomings will be resolved anytime soon. What would be needed is a complete deregulation of the common market coupled with a different approach. Rather than mandating how member states should write their rules, the European Commission should designate what cannot be regulated. This would dramatically decrease bureaucratic and compliance complexity. However, short of a trailblazing, pro-growth political leader taking over the EU Presidency, common sense deregulation remains elusive.

Follow the money

Don’t be fooled by headlines about the potential dangers to EU cohesiveness due to discord over immigration or other hot topic policies between conservative Eastern European governments and center-left Western European ones.

Consider Poland and Hungary, whose governments are the more vocal opponents of many EU policies. They receive 2.67% and 3.43% of their gross national income as transfers from the EU while spending less than 0.70% of their gross national income on EU membership. They are net beneficiaries of EU transfers to the tune of 2-2.5%, a non-negligible amount of subsidy that they receive annually. Despite their belligerent rhetoric over the political topic du jour, it would be financially ruinous for these net recipients to leave the EU. Compare that to the UK, which paid 0.46% into the EU while receiving only 0.28%, and where Brexit leads to a small net positive fiscal position [v].

Therefore, even the most vocal opponents of EU policy have little incentive for leaving the EU or seeing its disintegration by further departures. While direct subsidies are a substantial financial benefit to poorer and smaller member states, the main economic benefit comes in the form of the common market, without which many of the countries would be condemned to remaining economic backwaters. Therefore, warnings of a potential EU disintegration are pure hypotheticals that investors should take with a high degree of skepticism.

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 Thomas Kirchner has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016)

PKH Headshot - Sep 2015.jpg

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

 

[i] “Leopold I, King of Belgium.” Encyclopedia Britannica, Updated December 12, 2018.

[ii] “Frederic II, King of Prussia.” Encyclopedia Britannica, Updated August 13, 2019.

[iii] Eurostat. Table Code: tps00001.

[iv] Etienne Deschamps, “The beginnings of the ECSC.” CVCE.eu European Navigator, 2019.

[v] “EU member countries in brief” on Europe.eu.

 

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Originally published on http://www.camelotportfolios.com/commentaries

 

Reviewing the Major Macro Variables

By Paul Hoffmeister, Chief Economist

·      Here, in our latest monthly letter, we discuss US-China Trade, Fed and ECB policy, Brexit, the Hong Kong protests, and the 2020 elections. Given the increasingly weak global economy, the possibility grows that each could make or break the next year.

·      We believe President Trump’s negotiating strategy is becoming increasingly clear, and there are more levers he can pull to pressure China to concede to US demands. Given how much further Trump can go as well as the weak Chinese economy today, the odds are rising in our view that Chinese officials will compromise on at least some major demands in the coming year. A comprehensive deal, however, is a long shot – as that arguably would entail a wholesale reformation of the Chinese economic system.

·      Furthermore, we expect the Federal Reserve and European Central Bank to continue moving dovishly, and if conditions deteriorate further, they will need to do so in a big way – such as a 50 basis point cut at an upcoming FOMC meeting.

·      Prime Minister Boris Johnson shocked the world with his political maneuverings recently, and the probability of Brexit by the end of October has jumped significantly.

·      Hong Kong protests are a serious danger to the legitimacy of the Chinese government and the confidence in Hong Kong as an international financial center – if not during the near-term, then during the long-term.

·      Elizabeth Warren is arguably the front-runner for the Democratic nomination. Managed health care stocks have been notably weak during the last month.

 US-China Trade: In our view, negative news on the US-China trade front has sparked the two meaningful sell-offs of 2019. Of course, on Sunday May 5, President Trump accused Chinese officials over Twitter of renegotiating the terms of what appeared to be a tentative agreement, and so he promised tariff increases by the end of that week.[i] Then on August 1, Trump announced, again via Twitter, additional 10% tariffs on $300 billion of Chinese imports.[ii] In each instance, the new information seemed to indicate that US-China trade negotiations were devolving substantially.

This is reportedly supported by recent comments from top officials in both camps. In an interview on CNN last weekend, National Economic Council Director Larry Kudlow said he couldn’t promise a finalized trade deal with China by the November 2020 election.[iii] And according to Bloomberg this week, Chinese officials have said only a few negotiators see a deal as actually possible before then, “in part because it’s dangerous for any official to advise President Xi Jinping to sign a deal that Trump may eventually break”.[iv]

Screen Shot 2019-09-03 at 2.28.00 PM.png

In sum, the outlook for a resolution to the US-China trade dispute is very cloudy, and a slew of tit-for-tat tariffs have already been applied by both countries, and there are many more scheduled by year-end.

President Trump continues down two parallel paths, as we see it. The first path is the effort to reach a comprehensive agreement that addresses American grievances related to forced technology transfers, IP theft, fair market access, and Chinese state subsidies to domestic businesses. Assumedly, a partial deal would be met with the removal of some, but not all tariffs. The second path is the formation of a US trading sphere so as to create two international trading spheres with the US and China at the center of each.

Today, the prospects for a comprehensive trade deal with China are poor, while two distinct international trading spheres appear to be forming.

The Trump Administration has agreed to a revised US-Korea free trade agreement (September 2018) and the new US-Mexico-Canada Agreement or “USMCA” (June 2019), which replaced NAFTA. Furthermore, the White House is working on new trade agreements with Japan, the European Union, and the United Kingdom.

It appears that a deal with Japan is getting closer to being sealed as President Trump and Prime Minister Shinzo Abe agreed to “core principles” at the recent G7 meeting. It’s possible that the deal will be finalized within the next 1-2 months. At the same time, Trump and Prime Minister Boris Johnson have spoken positively about a major US-UK deal if Brexit happens. As for a US-EU deal, Trump struck an upbeat tone at the G7 meeting, saying “We’re very close to maybe making a deal with the EU because they don’t want tariffs.”[v] With this new US-centric trading sphere taking shape, it may explain why Trump seemed so upbeat about the G7 meeting.

Given the current circumstance, we expect President Trump to keep up the significant pressure on China to force into a more reciprocal trading relationship, and the path is unlikely to be smooth.

First, Trump could still apply more economic pressure possibly by raising tariffs even higher, utilizing the Emergency Economic Powers Act of 1977 to force US companies to divest from China, or even sanctioning Chinese companies or officials suspected of human rights violations.

Secondly, as the complex negotiations continue, it’s likely we’ll hear more mixed signals from President Trump. Asked by reporters at the G7 summit about his seemingly back-and-forth and changing statements on subjects such as President Xi and Iran, the President said, “Sorry, it’s the way I negotiate… It’s done very well for me over the years, and it’s doing even better for the country.”[vi]

Bottom Line: We believe President Trump’s negotiating strategy is becoming increasingly clear, and there are more levers he can pull to pressure China to concede to US demands. Given how much further Trump can go as well as the weak Chinese economy today, the odds are rising in our view that Chinese officials will compromise on at least some major demands in the coming year. A comprehensive deal, however, is still a long shot – as that arguably would entail a wholesale reformation of the Chinese economic system.

 Fed Policy: There are three more FOMC meetings before year-end, with the next one scheduled for September 17-18. At that meeting, federal funds futures are currently implying a nearly 96% probability of a 25 basis point rate cut, and 4% probability of a 50 basis point cut -- according to the CME Fedwatch Tool.

Arguably, the Fed must cut interest rates aggressively, and soon. The Fed is hostage to the market, trade negotiations, and other major macro uncertainties in the world today that are inhibiting risk-taking and production and thus slowing global economic activity. The inverted Treasury curve is another indication of the significant pressure on the Fed to cut interest rates. For example, the 3-month/2-year Treasury spread is approximately -47 basis points today, according to the St. Louis Federal Reserve. From our perspective, this implies that the market believes the funds rate is at least 50 basis points too high at the moment.

Is the inverted yield curve a signal of a looming recession? We believe that it’s an ominous signal, given its track record for preceding many recessions, and an indication of central bank error. But recession isn’t guaranteed. It’s still possible that aggressive rate cuts by the Fed and more clarity and resolution to many other macro uncertainty could re-ignite animal spirits and keep the United States from recession.

Notably, former New York Federal Reserve President William Dudley penned a highly controversial Bloomberg oped on August 27, in which he expressed a desire for the Fed to withhold interest rate reductions in order to not “bail out an administration that keeps making bad choices on trade policy”.[vii] It also appeared that Dudley went even further to suggest that the Fed pursue monetary policy into the November 2020 elections in a manner that prevented President Trump’s reelection.

But Dudley’s oped may backfire. It seems that the popular response to his oped has been critical, and ironically, may in fact turn the tables and force the Fed to prove that it isn’t acting in an “anti-Trump” manner by withholding rate cuts, but is purely economically motivated and therefore will reduce interest rates aggressively during the coming months. 

ECB Policy: At its next monetary policy meeting on September 12, it looks like the ECB will be meaningfully dovish, at least according to Olli Rehn, a member of the ECB’s rate-setting committee and governor of Finland’s central bank.

On Thursday, August 15, Rehn said, “When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker.”[viii]

We believe the ECB will lower its benchmark overnight rate by 10-20 basis points from negative 0.40% currently; announce new bond purchases (“quantitative easing”); and favorably adjust loan terms for EU banks.

As we indicated last month, the sharpest slowdown in growth globally may be occurring in Europe. It looks like the ECB is preparing to pull out the figurative monetary bazooka in a few weeks.

Bottom Line: We expect the Federal Reserve and European Central Bank to continue moving dovishly, and if conditions deteriorate further, they will need to do so in a big way – such as a 50 basis point cut at an upcoming FOMC meeting.

 Brexit: Prime Minister Boris Johnson has famously said that he’ll achieve Brexit by the October 31 deadline “do or die”. To that end, he shocked the world on August 28 by announcing that his Parliament will be suspended sometime between September 9-12, thanks to Queen Elizabeth II’s approval. Parliament will recommence after the Queen’s speech on October 14.[ix] This will give anti-Brexiters in the legislature little time to stop a no-deal Brexit by its lawfully mandated deadline.

Interestingly, the EU Council Meeting is scheduled to take place October 17-18. It appears that there are two possible scenarios emerging here: 1) if Johnson returns with a new Brexit deal, then he’ll hope to ram it through Parliament with less than two weeks to the deadline; or 2) if Johnson does not return with a new deal, then a no-deal Brexit may automatically occur by the deadline.

In sum, the probability of Brexit has increased substantially thanks to Johnson’s crafty political maneuvering. On August 28, the Predicit market for Brexit occurring by November 1 was 58 cents on the dollar; whereas the day before, the contract traded at 48 cents.[x]

Screen Shot 2019-09-03 at 2.29.06 PM.png

Importantly, to mitigate market volatility and economic uncertainty that could erupt with the UK’s exit from the European Union, Johnson should figure out how to quickly pass pro-growth policies, including business-friendly tax cuts and a new trade deal with the United States – both of which he has previously endorsed.

According to the Financial Times, Finance Minister Sajid Javid said two weeks ago, in his first interview since assuming his new role[xi], that he wanted to see lower taxes, but he did not commit to delivering the Johnson government’s budget proposal before Brexit day (October 31). Arguably, the Johnson government should be more aggressive here. One idea that’s been floated is lowering the UK’s corporate tax rate to as low as Ireland’s. This could be highly beneficial for the economy and markets. But, unfortunately, we haven’t heard much about it during the last month.

As for a US-UK trade agreement, at the recent G7 meeting, President Trump reiterated his desire and plan for a deal, saying “We’re going to do a very big trade deal – bigger than we’ve ever had with the UK.”[xii]

Bottom Line: Brexit by the end of October 31 is now our base case scenario, given Boris Johnson’s latest parliamentary maneuverings. We want to see a pro-growth plan, such as tax cuts and big trade agreements, implemented at the same time as Brexit transpires.

 Hong Kong Protests: The protests in Hong Kong since early June continue. And, in the latest turn of events, the Xinhua news agency reported yesterday that the People’s Liberation Army (PLA) had sent a new batch of troops and equipment -- including personnel carriers, trucks and a small naval vessel – into Hong Kong.[xiii] Although this rotation of troops has been reported to be routine, the potential of a government crackdown is seemingly growing, raising the risks of unintended consequences for the Asian financial hub and the region at large.

Bottom Line: The unrest in Hong Kong is a major risk to the Communist Party’s grip on power and the region’s economies – if not during the near-term, then during the long-term.

 2020 Elections: Elizabeth Warren’s prospects for becoming the Democratic presidential nominee seem to be growing. In fact, she could be considered the front-runner today.

On Predictit, the contract for her to be the nominee has risen to 34 cents on the dollar, compared to 22 cents on July 30. Bernie Sanders has risen to 16 cents from 13 during that time; while Kamala Harris has fallen to 10 from 24. The contract for former Vice President Joe Biden is trading roughly flat, around 26-27 cents.[xiv]

Given these betting market indications, it seems that with Warren and Sanders, the progressive wing of the Democratic Party is ascendant. And notably, with Medicare for All being a hot topic in the Democratic primaries, managed health care stocks have been especially weak during the last month. According to CNBC, the S&P 500 Managed Health Care Index fell 11.1% between July 31 and its low on August 27.

This sector may be a clear way to play bets on whether a Republican or Democrat wins the White House in 2020. We still believe, as we explained in April, that changes in American health care policy are likely in coming years, but a lot more needs to happen politically before a wholesale restructuring of the system occurs.

Bottom Line: Elizabeth Warren is arguably the front-runner to compete against President Trump for the White House in 2020. Her recent strength, as well as Bernie Sanders’s, may have spooked managed health care stocks in August.

PKH Headshot - Sep 2015.jpg

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

 *******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

A901


[i] “Trump Says He Will Increase Tariffs on Chinese Goods on Friday as He Complains about Pace of Trade Talks”, by David Lynch, Damian Paletta and Robert Costa, May 5, 2019, Washington Post.

[ii][ii] “Trump Says US Will Impose Additional 10% Tariffs on Another $300 Billion of Chinese Goods Starting Sept. 1”, by Yun Li, August 1, 2019, CNBC.

[iii] “Kudlow Can’t Promise China Trade Deal by November 2020, But Says Big Announcement Coming”, by Nick Givas, August 25, 2019, Fox News.

[iv] “China Prepares for the Worst on Trade War After Trump’s Flip-Flops”, by Peter Martin, Kevin Hamlin, Miao Han, Dandan Li, Steven Yang and Ying Tian, August 27, 2019, Bloomberg News.

[v] “Trump Sees Possible US-EU Trade Deal That Would Avert Car Tariffs”, by Jeff Masonl and Paul Carrel, August 26, 2019, Reuters.

[vi] “’Sorry, it’s the way I negotiate’: Trump Confounds the World at Wild G-7”, by Gabby Orr, August 26, 2019, Politico.

[vii] “The Fed Shouldn’t Enable Donald Trump”, by William Dudley, August 27, 2019, Bloomberg.

[viii] “ECB Has Big Bazooka Primed for September, Top Official Says”, by Tom Fairless, August 15, 2019, Wall Street Journal.

[ix] “Boris Johnson Just Took a Huge Step to Ensure Brexit Happens on October 31”, by Matt Wells, August 28, 2019, CNN.

[x] Source: Predictit.org

[xi] Sajid Javid Promises a Simpler Tax Regime”, by Sebastian Payne, August 17, 2019, Financial Times.

[xii] “After Brexit, a U.S. Trade Deal”, Wall Street Journal Editorial, August 28, 2019, Wall Street Journal.

[xiii] “China Sends Fresh Troops into Hong Kong as Military Pledges to Protect ‘National Sovereignty’”, Weizhen Tan, August 29, 2019, CNBC.

[xiv] Source: Predictit.org

Out of an Abundance of Caution

By Paul Hoffmeister, Chief Economist

·      Our general view from early July remains the same: “Until we see a more clarified economic outlook, risk management should be a growing priority in coming months. Arguably, this is the kind of environment where one should seek to secure and protect investment gains.”

·      It appears to be decades since this market has seen so many different, major macrovariables in play at the same time; each of which could impact asset prices dramatically.

·      As we see it: the global economy is slowing significantly, especially in the manufacturing sector; Brexit is likely to occur this year, deal or no deal (otherwise Boris Johnson risks the same political fate as Theresa May); US-China trade negotiations are unlikely to produce a comprehensive agreement anytime soon; and civil unrest in Hong Kong could spark a severe crackdown from Beijing.

·      The scariest chart today is possibly the US Treasury curve. If Fed rate cuts were going to more than offset today’s market risks, then why isn’t the Treasury curve steepening? Why is the curve inverting even more since the last FOMC meeting? The Treasury market appears to be signaling dark undercurrents to this market.

 On Wednesday, July 31st the FOMC cut its target range for the federal funds rate by a quarter point to 2.00-2.25% -- the first rate reduction since 2008. In the post meeting press conference, Chairman Powell said that he didn’t view this as “the beginning of a long series of rate cuts”.[i] He added, “You would do that if you saw real economic weakness… That’s not what we’re seeing.” As such, Powell framed the rate cut as a “mid-cycle adjustment.” Clearly, equity markets were disappointed with the decision, as the S&P 500 fell 1.1% for the day.[ii]

The next day, many US equity indices were up significantly but quickly sold off following a tweet by President Trump announcing additional sanctions on Chinese imports, which will begin in September. Later in the day, Trump said about Chinese leaders, “If they don’t want to trade with us anymore, that would be fine with me.”[iii]

The abrupt equity weakness in recent days brings to an end weeks of seemingly boring, upward drifting equity markets. Such is the market these days. It’s difficult to be wildly bullish (many things could easily pop up and catch you wrong-footed), and difficult to be severely bearish (the Fed-induced rally this year has made that clear).

Screen Shot 2019-08-12 at 11.36.55 AM.png

Ironically, though, when one looks at the performance (not including dividends) of theS&P 500 during the months following the initial rate cuts of the four previous rate-cutting cycles (which began in July 1995, September 1998, January 2001 and September 2007), the Index rallied 20% to 25% during the 12 months after the start of the 1995 and 1998 rate-cutting cycles, and sold off 10% to 15% after the start of the 2001 and 2007 cycles. Arguably, if history is any guide, one could easily get taken to the cleaners if they aggressively play this market incorrectly here.

Screen Shot 2019-08-12 at 11.37.16 AM.png

So how does one position themselves? I would recommend caution.

Contrary to Jerome Powell’s perspective, the global economy appears to be meaningfully slowing. According to Markit Manufacturing PMI data, 27 out of 28 countries had manufacturing PMI’s of greater than 50 in January 2018 – meaning the manufacturing sectors were growing in nearly all the countries that Markit monitors. In January 2019, 18 out of 28 countries showed manufacturing growth (PMI’s greater than 50). Unfortunately, as of June 2019, just 11 countries were showing manufacturing growth. The global slowdown is increasingly real.

 Even in the United States, which has enjoyed major corporate tax cuts and deregulation, the Markit manufacturing PMI for July registered 50.4, indicating that domestic manufacturing is on the verge of contraction. This is down from a high of 56.5 in April 2018.

 Most worrisome to us, though, is Germany’s Markit/BME manufacturing PMI, which registered 43.2 in July. This is down sharply from 63.3 in December 2017. As we assess the economic data globally, the slowdown may be sharpest in Europe.

 Arguably, it has been decades since this market has seen so many different, major macrovariables in play at the same time; each of which could impact asset prices dramatically.

 For example: the global economy is slowing (what will be the impact to levered industries highly exposed to growth, such as banks?); the UK’s new Prime Minister Boris Johnson is promising Brexit by October 31st, deal or no deal (we believe him and expect tough talk, otherwise Nigel Farage’s new, highly successful Brexit Party will look to gain even more political ground); US-China trade appears to be more about global geopolitical competition and supremacy rather than a mere trade disagreement (can China realistically make wholesale changes to its economic model, quickly and without serious unintended consequences?); and civil unrest in Hong Kong doesn’t seem to be dying down (will Beijing send in PLA troops to quell the demonstrations?).

 Even more, after having reportedly ruled out forex intervention to weaken the dollar, President Trump told reporters recently that he hadn’t ruled anything out.[iv] Uncertainty and volatility in the world’s reserve currency could have grave, far-reaching consequences. So far, we interpret the leak about dollar intervention and devaluation as a negotiating tool in the US-China trade talks. But it raises another substantial risk to the market today.

 Clearly to an optimist or equity market bull, these risks and uncertainties could be tinder to ignite another major rally. If these risks fade or get resolved, equities could arguably climb much higher.

 And importantly, not all is bad. At least the Federal Reserve is no longer purposely looking to slow economic growth with higher interest rates. And one notable uncertainty was clarified during the last month: impeachment risk. As we’ve suggested to clients, it appears that the Clinton impeachment hearings and related events in 1998 negatively impacted credit markets. Consequently, we believed it was possible that the pursuit of a Trump impeachment could have a similar, negative effect today.

 Interestingly, on July 24th, the day of Special Counsel Mueller’s testimony before Congress, the spread between Moody’s Baa and Aaa-rated corporate bonds narrowed 9 basis points from 100 to 91 – an usually large one day move. It appears the Mueller testimony has stalled the push for impeachment. As former counsel to the Senate Judiciary Committee, Gregg Nunziata, told Wall Street Journal editor Paul Gigot recently: “…pro-impeachment Democrats hoped that this hearing would kind of fan the flames of impeachment and create a national demand for impeachment over the summer. And it’s clear that far from fanning the flames, this is a wet blanket… So I think impeachment has become less likely, and I think we’re more likely to have Donald Trump face the voters in November [2020]. And the voters will render their judgment...”[v]

 Notwithstanding, the multitude of market risks or uncertainties appear to be creating dark undercurrents. The scariest chart today is possibly the US Treasury curve, which inverted even more during the days following the July 31st rate cut announcement and August 1st tariff news.

Screen Shot 2019-08-12 at 11.38.35 AM.png

According to the St. Louis Federal Reserve, the spread between 10-year and 3-month Treasuries was -2 basis points on Tuesday July 30, 2019. As of Friday, August 2, the spread trades around -19.

 If Fed rate cuts were going to more than offset today’s market risks, then why isn’t the Treasury curve steepening? Why is the curve inverting even more?

 As we see it, the current market environment warrants an abundance of caution. Brexit looms, US-China trade negotiations are devolving, global growth is slowing significantly. And perhaps the current Fed policy approach isn’t enough. Most likely, the Fed will align with the market, and the recent rate cut will no longer look like a “mid-cycle policy adjustment”. As such, we are likely to see more disappointing economic data and more volatility in risk asset prices.

*******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified. A899

PKH Headshot - Sep 2015.jpg

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).


[i] “Fed Cuts Rates by a Quarter Point in Precautionary Move”, by Nick Timiraos, July 31, 2019, Wall Street Journal.

[ii] Ibid.

[iii] “Trump Says It’s “Fine with Me” If China Doesn’t Want to Trade With the U.S.”, August 1, 2019, CBS News.

[iv] “Trump Suggests He Could Take Steps to Weaken U.S. Dollar, Fueling Confusion”, by Damian Paletta, July 26, 2019, Washington Post.

[v] Interview, “Wall Street Journal Editorial Report”, July 28, 2019, Wall Street Journal.

June: A Confluence of Positives

By Paul Hoffmeister, Chief Economist

·      During the last month, we’ve seen a confluence of positives in some of the major macro variables: Fed policy, trade and Brexit.

·      To us, the latest macro developments are very encouraging. But the equity market outlook remains tricky, and we do not believe it’s a one-way ticket up in equities for the third and fourth quarters.

·      My biggest concern at the moment is the slowing global economy, which is permeating into the United States.

·      Until we see a more clarified economic outlook, risk management should be a growing priority in coming months. Arguably, this is the kind of environment where one should seek to secure and protect investment gains.

During the last month, we’ve seen a confluence of positives in some of the major macro variables. Most notably, Chairman Powell said on June 4th that the FOMC was prepared to act in response to the economic outlook, including the trade disputes with China and Mexico.[i] His comments suggested that interest rate cuts were on the horizon, sparking a 2.1% rally in the S&P 500 for the day.[ii] The rally marked the beginning of the recent turnaround in equities after the weakness we saw in May. 

The next FOMC meeting is July 30-31. And as of July 1st, according to fed funds futures and the CME’s FedWatch Tool, the probability of rate cuts by the end of July are 100%.

Arguably, the Fed outlook has been the most important macro variable of the last year. From our perspective, Powell’s comments on October 3rd that the fed funds rate was a long way from neutral catalyzed the beginning of the multi-month selloff in equities, and his pledge on January 4th that the Fed would be patient with any further rate increases laid the foundation for this year’s rally. [iii] [iv] And now more recently, we have Powell seemingly coming to the stock market’s rescue.

Screen Shot 2019-07-11 at 3.29.08 PM.png

During the last month, we’ve also seen positive developments on trade and Brexit.

Of course, Presidents Trump and Xi agreed to restart trade talks during the G20 meeting at the end of June. Trump promised to hold off on putting a 25% tariff on nearly $300 billion of Chinese imports, and he lifted some restrictions on Huawei. Meanwhile, Xi reportedly promised to start large scale purchases of American food and agricultural products.[v]

In addition to renewed hopes for a US-China trade deal, American and Mexican negotiators reached a deal on June 7th in which the Mexican government agreed to take new measures to curb the influx of Central American migrants into the United States. This averted new tariffs on Mexican imports.[vi]

There was also some good news on the Brexit issue. While Brexit still appears to be on track to occur by October 31st, Boris Johnson -- the frontrunner to become the UK’s next prime minister – has promised to cut personal income and corporate taxes. This follows Jeremy Hunt, another contender for Prime Minster May’s job, who wants to reduce the UK’s corporate tax rate from 19% to 12.5%.[vii]

As we’ve stated in the past, news during the last year of a Brexit divorce not occurring seems to have been received positively by financial markets. Nonetheless, we’ve believed that Brexit could happen without being disruptive to markets if it was combined with new, pro-growth policy measures. Major tax cuts (such as lowering the UK’s corporate tax in line with Ireland’s 12.5% rate) and new trade deals (Trump keeps dangling a major post-Brexit, US-UK trade deal) could be exactly the pro-growth package that turns Brexit from a market negative into a market positive.

The confluence of positives related to interest rates, trade and Brexit appear to have been the predominant catalysts behind the strong equity market performance in June. This begs the question, do we have clear skies for the remainder of the year? After all, it appears that we have a Fed that won’t be raising rates, the US and China will continue to negotiate their differences, and Brexit could go through more smoothly than expected.

To us, the latest macro developments are very encouraging. But the equity market outlook remains tricky, and we do not believe it’s a one-way ticket up in equities for the third and fourth quarters.

Fortunately, we now have a Federal Reserve that’s seemingly not acting to slow growth anymore with rate increases. Instead, it’s planning to support growth with interest rate cuts. This factor alone should mitigate downside risks significantly. But the US-China negotiations are only being restarted and much work needs to be done to reach a comprehensive deal. Steve Bannon, once a top advisor to President Trump and one of his staunchest supporters on China trade policy, suggested in a recent CNBC interview that a comprehensive deal may not even be reached by the end of 2020.[viii] Furthermore, Brexit is a delicate issue that must be paired with strong growth-friendly measures that can pass the UK Parliament, which remains uncertain.

My biggest concern at the moment is the slowing global economy, which is permeating into the United States.

As we’ve shown in recent months, GDP for the major foreign economies (China, Japan, Germany and UK) has been slowing, while US GDP has been accelerating. But economic data at the margin suggests that the strength in the US could fade.

According to the Institute for Supply Management, the US Manufacturing PMI Index peaked at 60.9 last August, and June’s reading was 51.7 – down from 52.1 in May and 52.8 in April. [ix] Note, readings below 50 signal contraction in the manufacturing sector. We have warned that should this reading fall to 50 or less, the US economy will be at a heightened risk of entering recession.

As for the services sector, the ISM non-manufacturing index fell to 55.1 for June, down from more than 60 during the second half of 2018.[x] This is the weakest level in almost two years.

It’s economic deterioration such as this that likely underpins the Fed’s motivation to reduce interest rates, despite the fact that the S&P 500 is trading near all-time highs. 

Perhaps the most important questions today are: 1) will a 25 basis point reduction in the federal funds rate on July 31st be enough to arrest or reverse the negative economic momentum around the world?; and 2) will positive developments in the major macro variables reinvigorate animal spirits and promote new economic production?

I’d suggest neither are enough just yet. While equities were up big in June, credit market behavior has been uninspiring, which could be signaling something ominous underway in the global economy.  

Much of the US Treasury curve remained inverted during the last month. For example, between May 31 and June 30, the spread between the 3-month and 2-year Treasuries only steepened from approximately -42 to -34 basis points -- according to the St. Louis Federal Reserve. These are levels that we saw during the fall of 2000 and 2006, periods that preceded an eruption of systemic risk.

Screen Shot 2019-07-11 at 3.29.22 PM.png

Meanwhile, month-over-month, the St. Louis Federal Reserve shows that the spread between Baa and Aaa-rated corporate bonds widened from 100 to 106 basis points. This suggests that systemic risk concerns in June grew slightly.

As we see it, the good news is that June brought positive macro event catalysts, and holding all variables constant, one or two quarter-point rate cuts by the Fed could get the Treasury curve out of inversion. But the current inversion in the Treasury curve should be respected, and it will be important to see global economic growth stabilize after almost a year of deceleration. Until we see a more clarified economic outlook, risk management should be a growing priority in coming months. Arguably, this is the kind of environment where one should seek to secure and protect investment gains.

PKH Headshot - Sep 2015.jpg

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of  Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

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Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.





[i] “Stocks Jump as Fed’s Powell Suggests Rates Could Come Down”, by Jeanna Smialek and Matt Phillips, June 4, 2019, New York Times.

[ii] Ibid.

[iii] “Powell Says We’re a Long Way from Neutral on Interest Rates, Indicating More Hikes Are Coming”, by Jeff Cox, October 3, 2018, CNBC.

[iv] “Powell Says Fed ‘Will be Patient’ with Monetary Policy as It Watches How Economy Performs”, by Jeff Cox, January 4, 2019, CNBC.

[v] “Trump and Xi Agree to Restart Trade Talks, Avoiding Escalation in Tariff War”, by Peter Baker and Keith Bradsher, June 29, 2019, New York Times.

[vi] “Trump Announces Migration Deal with Mexico, Averting Threatened Tariffs”, by David Nakamura, John Wagner and Nick Miroff, June 7, 2019, Washington Post.

[vii] “Boris Johnson Promises Tax Cut for 3m Higher Earners”, by Rowena Mason, The Guardian, June 10, 2019.

[viii] Squawk Box, June 27, 2019, CNBC.

[ix] “US Factory Gauge Drops Less Than Forecast But Orders Stall”, by Katia Dmitrieva, July 1, 2019, Bloomberg.

[x] “US Services Gauge Drops to Lowest Since 2017”, by Jeff Kearns, July 3, 2019, Bloomberg.